Nika Koreli

Strategic default increases the expected recovery rate from bankruptcy, which is a costly event. When investors cannot commit upfront to bankrupt defaulting borrowers, recovery rates are essential in sustaining investment, and optimal financing contracts may generate incentives for borrowers to strategically default on their debts ex post. Where bankruptcy costs are high (at the extensive margin), strategic default is necessary for the marginal firm to be able to invest. Where costs are low (at the intensive margin), high profitability firms optimally choose financing terms that induce strategic default, even if this is anticipated by all parties and other feasible terms could prevent it. These firms are characterized by high probabil- ity of default and low expected losses given default. It follows that distinguishing between credit events is critical for estimating expected default costs.